UNFAIR VALUE

On Feb 27, 2009, the promoters of a little known aluminum producer from southern India, Madras Aluminum Company (MALCO), came out with a delisting offer[1] for the company, after their failed attempt to delist the same company 4 years ago. The indicative price of 105 per share is little more than double from what they had offered last time (Rs 48 adjusted for split).

There are 3 facts that have made this interesting enough to warrant this article.

It's a text book case of how the promoters manage to take advantage of the volatility in prices, in a perfectly legal way, by issuing new stocks during booms and buying them back when times are bad. I feel that the analysis of the case will equip the readers of this newsletter with reasoning to handle such cases in future.

Unlike the case of buying or selling from regular markets, where the price is offered to you, the exiting investors of the company are supposed to quote the price at which they want to sell. Most small investors do not have the skills required to arrive at a valuation of the company. They look at the market prices as a guide. But in this case the price of the stock has been quite volatile as it is thinly traded and it has been party to a mammoth restructuring attempt last year to put an elephant's head on the shoulder of a human child. Except in Hindu mythology, such attempts are doomed to fail. This restructuring attempt, to merge group company Sterlite's aluminum and energy businesses to MALCO, the latter being one tenth in size, fell flat on its face in a matter of a week. This week-long euphoria catapulted the price of MALCO to 225 Rs and the inevitable post-euphoric gloom brought it crashing down to Rs 34. The talk of delisting has given a dose of Viagra to MALCO and it has shot beyond Rs. 100. Now the task in front of the small investor is: Name the price at which you want to sell! If you own MALCO yet can't answer this question, this artcile will help you.

MALCO is the second biggest holding in my portfolio and this stock on its own has earned me more profits in my investing career than all my other stocks combined. Naturally, I'm not willing to sell my precious holding without getting a good price for it. But the actions of my fellow shareholders affect me because if they sell out cheap, I may be forced to sell out or become a private investor. I'm not averse to the second option (which, as a matter of fact, I did choose, and quite profitably, in case of Eicher Ltd.). However, the prospect of being at the mercy of promoters, to send me dividend, makes me rate selling out as the first option. Hence, this attempt to help the MALCO investors in determining the price they should seek from the promoters, indeed, has a very personal objective too (and I feel it is most fair to take up the issue through my ‘unfair' means).

A (not-so-brief) History

Madras Aluminum Company is a small aluminum producer catering to the demand from south India. In 2008, it produced 37,635 MT of aluminum, which is one tenth of the production of the large producers like NALCO and BALCO. MALCO is part of the Vedanta group, which in total produces around 0.3 MMT of aluminum. The company (MALCO) is riddled with the problem of high cost due small scale and high cost of imported coal. These difficulties led the company to the brink of failure and it was referred to BIFR in the ‘90s. In 1997, the company came out of BIFR and since then it has produced moderate profits though there hasn't been much growth in volume.

The key to the valuation of MALCO is its 3.97% stake in another group company – Sterlite Industries. Sterlite's history has many twists that are similar to that in MALCO, primarily because the promoters have used the same strategy to increase their ownership by buying back shares from the public when the industry is not doing well.

Sterlite Industries is the largest non ferrous metals producer in India. In the 1990s, Sterlite produced only copper but during the disinvestment in 2001, it managed to get hold of two large PSUs, BALCO and Hindustan Zinc. The controversy regarding the price of BALCO led to agitation which caused production shutdown at the company?. This led to a major fall in the price of Sterlite (and I managed to buy stocks of Sterlite at dirt cheap prices). The promoters of Sterlite were aware of the gap in price and value. The company proposed to buy back 50% of its equity at a price slightly above the then prevailing depressed price. They went to the extent that any shareholder who did not, explicitly, reject the buyback offer, was deemed to have given acceptance to sell. The court ratified this crazy buyback arrangement. Many investors, like myself, did not receive the forms to be able to decline the buyback offer. After pressure from investor groups, the promoters gave 3 months time to the investors, who had not yet returned the forms to decline the buyback (and I screamed NO.Under normal circumstances, I would sell off my stake in any company that tries to cheat the investors but in this case, the eagerness of the promoters to buy back, was a clear endorsement my own valuation of Sterlite.)

After delisting, the promoters created a holding company Vedanta and listed it in the UK for a few billions. In one single stroke of financial wizardry, the Sterlite promoters created billions for themselves in a perfectly legal yet utterly dishonest way.

Sterlite, using the cash from the UK listing (transferred via rights issue), increased its capacity manifold and became a non ferrous metal giant even by global standards. Last year, Sterlite (consolidated) produced 0.34 MMT copper, 0.42 MMT zinc and 0.36 MMT aluminium and earned around 1.5 billion dollars in profit. They are still hungry for growth and each line of business has plans to expand the capacity further.

In July 2004, while analyzing MALCO's financials, I found that if I sold my Sterlite shares and bought MALCO, I would not only increase my holding of Sterlite (indirectly via MALCO's stake in Sterlite) but also get my share of MALCO's standalone business for free. I jumped at the opportunity. I sold Sterlite at 2.5 times the price I had paid 3 years ago and bought MALCO. The stock was so thinly traded that in that week, I bought one third of all the shares sold in BSE during the week (and those weren't too many!).

In year 2005, MALCO earned a profit of Rs 59.8 crores yet its price remained depressed. Smelling the opportunity, the promoters came out with a plan to delist the company. They already head 80% of the company. They offered a price of Rs 240 (pre split) which valued the company at Rs 540 crores. Imagine a company, making Rs 59.8 crores net profit and holding 4.61% stake in Sterlite, going for Rs 540 crores! Luckily, the investors didn't like the price. The promoters managed to get only 5.56% of the stocks. (Interestingly, the Tamil Nadu Industrial Investment Corporation Limited, which holds 3.11% in MALCO asked for a price of more than Rs 2,000. Bravo!). The delisting bid failed because the promoters needed at least 10% shares.

The company, meanwhile, made more profits. In the 9 months ending March 2007, it made a profit of 135.3 crores. The stock price went all the way up to 900 where I sold my stocks making a gain of around 8 times. Soon, the metals market collapsed and I re-entered the stock at a lower price.

Things were going well when the Vedanta group announced its plan for restructuring the business[2]. In theory, the plan was ok because it makes sense for one group company to focus on one line of business. However, the plan was hopelessly complicated. It was a 4-step plan to move the group's entire energy and aluminum business to MALCO and its copper business to Sterlite. The restructing affected as many as 10 group companies and 6 of these were publicly listed companies. The minority shareholders in each company felt that they had been cheated. Vedanta was forced to drop the plan due to stiff opposition from investors.

In the restructuring plan, the shareholders of MALCO had a chance to unlock the value of their investment and that made the price shoot up from Rs 145 to Rs 225. At the same time, the price of Sterlite fell because its investors felt cheated. When the plan was dropped, both the stocks fell sharply. At the same time, the metal prices all over the world crashed and this dealt a double whammy to MALCO's price. The price kept falling all the way to Rs 34 in November 2008.

MALCO being a high cost producer was most impacted and it had to cut its production by 60%. In the quarter ending December 2008, it lost Rs 7.1 crores. Amid all this, the promoters of MALCO launched another attempt to delist the company.

After the restructuring plan was dropped, Vedanta had said that it remained committed to restructuring. It is quite obvious that they cannot bring the same restructuring plan to the investors. So they are doing what makes sense for them. If they buy out MALCO and make it part of Vedanta, there will be one less external party in the restructuring. At least for their aluminum business, it opens up a path to merge all group entities in that business into one single company.

Valuation rationale

The markets never assigned the full value of MALCO's stake in Sterlite because in such cases there is no fixed timeline when the value of that stake will be unlocked. However, the promoters are in the business for the long term. For them, the value of the business is taken in its entirety. That's why it makes sense for the promoters to buy out the minority shareholders if they can.

The minority shareholders on the other hand have many things going for them.

The book building process allows them to ask for any price above Rs 74.77. If they quote a price too high, say 225 Rs and the promoters manage to get the desired 10% stake at a price well below, say 150 Rs, they will still get 6 months to sell out at the same price as offered to the other shareholders.

As they are selling out to a long term investor, the valuations should not be based on recent results or depressed commodity prices or the prevailing market condition.

The stakes for the acquirer are high. They would not like to fail for the second time because it raises the price of acquisition. Secondly, this delisting will decide the fate of their restructuring plan. If they believe that restructuring is beneficial for the group, they wouldn't mind paying a little bit extra for the 30% stake left with the public.

The public stake in the company is concentrated among a few strong hands. Out of 20%, the financial institutions hold 12.33%, corporates hold 3.62%. Only 3.31% is held by small investors.

Simply put, it's payback time for MALCO shareholders. They MUST get the value of their holding and avoid selling out cheap. There is nothing to lose.

Interestingly, the promoter has passed a resolution on the maximum price they will pay. The delisting offer reads[1]….

The acquirer has vide its resolution dated February 25, 2009, approved a price not exceeding Rs 105 per equity share for the Delisting Offer. However, this should in no way be construed as (i) a ceiling or maximum price for the purposes of the reverse book building process contemplated herein, and the Shareholders are free to tender their equity shares at any price higher than the Floor Price; or (ii) a commitment by the Acquirer to purchase 2,25,00,000 equity shares of the Company if the Discovered Price is Rs 105 or less; or (iii) any restriction on the ability of the board of directors of the Acquirer to modify the aforesaid resolution

Only the last line has some meaning. Forget Rs 105. Quote your price. Accepting or not it their business.

Valuation

Let's try to arrive at the value of the stock.The methodology I'll follow here is what I call “Common Sense” method. (those preferring fancy discounted cashflows valuation are free to do it on their own)This method, includes separating the assets which have diverse characteristics and valuing them individually and then adding them up.

With this methodology there are 3 key contributors to MALCO's value.

The cash and bank balances

The value of future earning

The value of its 3.97% stake in Sterlite

Cash is valued at it's value. For valuing the future earnings part, I take the average earnings of the company for last 9 years after excluding income from interest and dividends. I used a conservative multiple of 10 times earnings to arrive at the value of these earnings. This ballpark figure will give you the absolute minimum price below which there is no question of selling out.You can value the stake in Sterlite in different ways. You can use the average market price of the stock. You can also say that Sterlite itself is undervalued today and ask for a price by capitalizing the earnings of Sterlite at a conservative multiple.

With different criteria, here are the valuations we arrive at.

Basis

Valuation of MALCO

Valuation of MALCO

Valuation of Sterlite

Rs Million

Rs Per share

Rs Per share

Malco at book value

9820.3

87.3

235.4

Malco at 10 times average earning + Sterlite stake at book value

13875.5

123.3

235.4

Malco at 10 times average earning + Sterlite stake at market price

14145.0

125.7

245.0

Malco at 10 times average earning + Sterlite stake at 6 month average market prive

15995.8

142.2

310.0

Malco at 10 times average earning + Sterlite stake at 3 year average market price

23493.1

208.8

577.4

Malco at 10 times average earning + Sterlite stake at 10 times average earning

18539.9

164.8

401.3

# For details check the valuation worksheet [3]

Most people will be skeptical about the earning potential of Sterlite and MALCO given the present conditions. However, the 9 year period takes into account a complete cycle of boom and bust. With Sterlite, I have used average of last 4 years because the company has grown many many times in terms of physical output.

I personally feel that the price of 164.8 is the fair price because it values Sterlite correctly at Rs 401.3 per share. Remember, Sterlite had an earnings per share of Rs 65.19 and it's book value is 235. The company is sitting at cash and cash equivalents of Rs 19000 crores which are enough to sail through the troubled times.

Final Verdict

As described above, the valuation of 164.8 Rs per share looks fair value to me. But why should I sell out at fair value?

I've invested in the company to earn profits. I've invested with the belief that in coming decade, MALCO will do better than the last decade. I also believe that its stake in Sterlite will be valued far more than the conservative valuation I have done by taking a price of 401.3 per share for Sterlite. In last one year Sterlite had touched a high of Rs 990.00 and that value doesn't look out of reach in long term given the expansion plans. Sterlite is one of lower cost producer in all the metals it produces. It is in a better situation to weather the downturn than many high cost producers, MALCO included.

At the same time, I feel that the promoters have all the reasons to delist the company. When the promoters know that the investors will make a beeline for their IPO, they charge substantial premium above the fair valuation of the business. When we are not in hurry to sell and promoters seem in a hurry to buy, why shouldn't investors expect a premium above fair valuation?

Based on this, I feel that a minimum premium of 20% above the fair value of the stock is required to make me think about selling.

So here is the verdict.

Unfair Value vide its resolution dated March 1, 2009, approves a price not less than Rs 197.76 per equity share for accepting the Delisting Offer. However, this should in no way be construed as a ceiling or maximum price for the purposes of the reverse book building process contemplated herein, and the Shareholders are free to tender their equity shares at any price higher than this price.

As per SECURITIES AND EXCHANGE BOARD OF INDIA (DELISTING OF SECURITIES) GUIDELINES – 2003, section 8.5, In the event of MALCO being delisted at a price less than 197.76 rs per share, the acquirer will allow a further period of 6 months for any of the remaining shareholders to tender securities at the same price. If that happens we reserve the right to reconsider the price and decide to sell out or continue as a private shareholder.

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comments:

Exhaustive report. Thanks Kamlesh. However the sentence below needs correction."When we are not in hurry to sell and promoters seem in a hurry to buy, why should investors expect a premium above fair valuation?"It should have been... why should'nt investors expect a premium....

The valuation of MALCO above has been done on basis of its value to long term investor. The premium attached to the price is the control premium which is typical of large transactions involving management change/delisting or any other strategic benefit that are available to the buyer.

I want to clarify that the suggested price of 197 does not mean that people should jump to buy it at current price of 103 in the hope of doubling their money in a month. Such a bet is purely speculative and has a chance of ending in steep losses if the promoters decline to accept the discovered price. Such a scenario, which can result in price falling back sharply, has disastrous consequences for short term investors. Long term investors can afford to ignore such price fluctuations.

thank you very much kamlesh for bringing uo this calculation to all.i have 5000 shares and i am not going to accept anything less than rs 200.mr anil agarwal has proved once again that he started as a scrap dealer and i hope that he ends as a scrap dealer only. he cannot come on par with tatas in the next 100 generations.naresh

When the 6 month deadline for open offer to remaining investors expires, they become private investors. They have no market to sell their shares to except to the promoters. I don't think you will be able to bargain with the promoters, so if you want to sell off, do it now.

For the investors who invest in a business, as opposed to a stock, it doesn't matter if the stock is not listed. You do get dividends. You have all the rights that the majority shareholders have.

But you should note one thing. Should the management infringe upon those rights, you will have to take them to court which may not be a feasible option if you hold small number of shares.

I had declined the delisting offer from Eicher Ltd and I became private investor. Later I got slightly better deal from the promoters and I exchanged my stocks for bonds. Such a thing may or may not happen in other companies.

Illegal executies inside the company chit chatting and eating the assets of promoters.Then wont the shares get delisted leading a loss to people and promoters killing the vision of board and ordinary people

well, I don't think you can do much except waiting to hear from the promoters or any other buyers. You can approach the company to see if they are interested in buying your stocks. This may not be easy because you will have to find the right contact people in the company. A call to their registered office may help.

At the same time, you don't need to panic because you own just the same percentage in the company as you did before delisting. You are entitled to dividends and all other rights that come from part ownership. Though I've no way to substantiate my claim but the company will approach you within next few years. It makes sense for them to buy you out.

Some of you had written that you are stuck with MALCO shares. The promoters have made another offer at the same price(115) and you would have got a letter from them. IF you want to exit, you have an option.

Dear Kamlesh, Is it worthwhile to exit at the revised offer of Rs. 115 ? I don't mind holding on to the stocks, but the fear remains that the company might be stripped off its assets by the promotors and made a shell company

When i decided to remain invested, I had made 4 assumptions.(1) The price of Sterlite does not reflect it's true value.(2) the price of MALCO doesn't reflect true value of it's own business, let alone it's stake in Sterlite(3) Delisting does not mean that you will have no option sell. The promoters know that the company is valuable and they will try to get shares from you.(4) The other significant shareholder Tamil Nadu Industrial Investment Corporation Limited(TIIC), which holds 3.11% in MALCO, is unlikely to sell. This will keep the promoters from asset striping.

All of these assumptions have come true. Malco made enough profit this year to justify the valuation of Rs 115 without putting any value on sterlite stake. Sterlite has gone substantially up since the time this message was posted. And you do have an option to sell if you want. Finally TIIC did not sell MALCO.

Things are going as I had predicted and I see no reason to sell.

At the same time, I don't think any investor should try to copy what I do because I operate with a different mindset and with different financial situation. If you financial situation forces you to sell out now at 115, you made a mistake by not selling it during delisting.

It is not now or never for MALCO shareholders. It is another attempt by the promoters to get your shares cheaply.

The last split was on24/07/2008 when the Stock Split from Rs. 10/- to Rs. 2/-

There is nothing wrong in selling out if you need liquidity. I'll continue holding on because in my opinion, the value of the company is more compared to the valuation I had arrived at in this article.